In a Synthetic Call Option, the investor can create a pseudo call position by buying puts that equal the number of shares they own. Just like a call buyer can buy in-the-money, at-the-money, out-of-the-money options, a person who is long stock can buy in-the-money puts, at-the money puts or out-of the-money puts to protect the stock. For example, if a person buys 100 shares of stock at $50, they can buy a $55 put option to protect the position. That put is in the money, and the downside is very limited. Unfortunately, the stock has to rally all the way above $55 for the position to defray the cost of the put and make money. This trade would be equivalent to buying a $55 call. The call option is way out of the money, but it does not cost much so the downside is limited. If the stock rallies above $55, the upside is unlimited, just like being long the stock. You can work through this exercise with the $50 puts and $45 puts.
Synthetic Call Option
January 3, 2009